Hedge funds are so over that they’re not worth worrying about

We’ve another of those worrywart articles over in The Guardian. All about how awful hedge funds are, what a bad deal they are and how much power they have. The problem with the situation as laid out is that, as Adam Smith pointed out, the solution is already there in the situation as it is laid out.

Are these sophisticated investors making sophisticated investments? It’s hard to find the proof that they are. By many measures – and it is hard to measure – hedge fund returns are pretty much just average. That hedge funds can charge such high fees for such average returns has economists and many others confused. It’s not exactly rational. Theories abound.

Smith didn’t use quite these words but to condense his usual several thousand of them down to a blog post.

Capitalists like profit: there’s also an average rate of profit across an economy (we would add “risk adjusted” to that these days). Given that like of profit everyone’s always on the look out for ways of making above that average (risk adjusted) rate. And sometimes people do find them: this can be anything from inventing the smartphone to running the logistics chain of a supermarket better to a new method of investing on the public markets.

Precisely because the capitalists like profit they observe that lucky blighter who has found that better than average (risk adjusted) profit and so they all move some of their capital into copying that activity. At which point that higher than average profit starts to slip away given that there are many more people chasing it.

Or as they might say in the financial markets, no arbitrage opportunity survives the general knowledge of its existence. And as we can say about the economy in general, innovation can lead to economic profits, which then get competed away over time by the competition that comes from copiers.

And we’re just fine with this: we consumers get the new products, eventually, at the average profit rate for the economy, those transient economic profits from the innovation being what encouage people to create those new products. This is as true of shiny shiny tech as it is of logisitics chains and financial markets.

Hedge funds are no different. It’s definitely true that in their early days, when they were new, they were making economic, above that average, profits. As the complaint itself observed today they’re not. They’ve grown massively in size over that time. Competition has reduced those economic profits to the average of the economy.

Why worry? Everything is working out just as Adam Smith pointed out it would.